In 2012, JC Penny launched an initiative to do away with “fake pricing”. Instead of making customers wait for a sale, the idea was to always offer a discounted price. A coffee table that would otherwise have been discounted from $300 to $150, would always sell for $150 in the new system.
This strategy failed. Customers would see a t-shirt selling for $15 and assume that it was cheap and low quality. Customers lost the irrational sense of reward they once had when they found a $30 t-shirt marked down by 50%. The strategy did so bad that JC Penny reversed course a year later. This about-face was accomplished by simply raising the price of everything and then discounting them back down again with that familiar red line. This simple magic trick worked, and people returned to the stores.
This whole saga was a master course in how irrational shoppers can be. Shoppers need a cue that allows them to think they are making logical and value-driven purchasing decisions. This cue is known as anchoring, and it is the subject of today’s post.
Wikipedia defines anchoring as:
the common human tendency to rely too heavily on the first piece of information offered (the “anchor”) when making decisions.
Investopedia defines it this way:
Anchoring is the use of irrelevant information as a reference for evaluating or estimating some unknown value or information. When anchoring, people base decisions or estimates on events or values known to them, even though these facts may have no bearing on the actual event or value.
Basically, we are over influenced by irrelevant information acting as a reference point for future judgements. For example, we might use how much we are currently paying in rent as a reference point for how much rent would cost in a bigger apartment. We would just add a few hundred dollars to our current rent. In this case, we would be anchoring our estimate to our current rent.
The anchoring and adjustment heuristic was first theorized by Amos Tversky and Daniel Kahneman. They devised an experiment in which participants were asked to compute, within 5 seconds, the product of numbers either displayed as 1x2x3x4x5x6x7x8 or 8x7x6x5x4x3x2x1. Participants would guess larger values when 8 was displayed first and lower values when 1 was displayed first.
In another experiment, participants observed a roulette wheel that was set to stop at either 10 or 65. The participants where then asked to estimate the percentage of African nations in the United Nations. Participants whose wheel stopped at 10 consistently guessed lower that participants whose wheel stopped at 65.
These results have held up in a variety of different experiments testing the anchoring effect.
As it relates to negotiating
If you have ever bought a car, you are probably familiar with the negotiating dance that takes place. The salesman always anchors the buyer to a high price and then slowly reduces it. The goal is to get a good final price and still have the customer perceive that they got a good deal.
In a similar way, the price of buying a business is usually anchored to what similar businesses have sold for. If text messaging apps are being sold for billions of dollars, when it is your turn to sell you are going to want billions of dollars. If our neighbor sold their home for $500 thousand, we are going to want at least $500 thousand for ours.
If we are a buyer, we want to anchor a low price as soon as possible. If we are a seller, we want to anchor a high price.
As it relates to management
Tomas Peters, the author of In Search of Excellence, once explained the formula for success:
Under promise and over deliver.
Management has an incentive to anchor expectations low so that they can subsequently beat those expectations. For example, if a project is 10% over budget, it’s in the project managers interest to claim that the project is 30% over budget. When the results are revealed as 10%, the project manager will be viewed as a hero rather than a failure.
As it relates to investing
When we pay $30 for a stock now worth $50, we feel like geniuses. When we pay $30 for a stock now worth $15, we feel like idiots. In both cases, we are valuing the stock by its relative price to our purchase.
What we should be doing is valuing the stock relative to the businesses actual value. If it is now worth $50, but the underlying business has deteriorated, we should sell. If it is now worth $50, but the underlying business has boomed, we should buy. In neither case should our purchase price matter.
Investors tend to take anchoring even farther, as they will refuse to sell a losing investment. They insist that the price will return to what they purchased it at. Warren Buffett summed up this idea in an interview with Forbes:
The stock doesn’t care what you paid, remember the stock doesn’t even care that you own it. You are nothing to the stock, that stock is everything to you, and you remember you paid $10.13 and therefore the stock should get to $10.13 before you sell it. Yes… the stock has no feelings about you. I hate to disillusion you on this. It just doesn’t care.
There is nothing about the price action of a stock that tells you whether you should keep owning. What tells you whether you should keep owning is what you expect the company to do in the future versus the price at which it is selling now compared to the other opportunities of businesses you think you know equally well and make that same comparison.. and that’s all there is to owning stocks.
Anchoring bias occurs when we are over influenced by irrelevant information acting as a reference point for future judgements. In order to make better judgements, we should always consider choices from a zero base level. In investing, this means we should always adjust our decisions based on reality and not the price we paid for a stock. I’ll end with this Charlie Munger quote from the 2016 Berkshire annual meeting:
We try to avoid what is always the worst anchoring effect, which is our previous conclusions.